CDs vs bonds

While CDs are often thought of as different assets than bonds, in reality they are simply bonds with special characteristics. These differences and similarities will be explored below.

Because CDs, like U.S. Treasuries, are backed by the full-faith and credit of the U.S. Government (when purchased properly), Treasury Bonds are the appropriate comparison.

The following primarily applies to un-brokered CDs of greater than 1 year maturity, with no particularly exotic options (e.g. a simple coupon-paying CD with no call option). As this is by far the most common type of CD, and is what most people mean when they say "CD," this will allow the analysis to be simple yet relevant.

Contents

Characteristics and risks

In general, assuming yields are equal, CDs perform better if interest rates rise (because of their put option[1] and because if the bank fails you get the par value back, not the lower present value), whereas Treasuries are preferred if interest rates fall (since their liquidity means you do not have to wait until maturity to profit from the rate change and because if the bank fails you get their higher present value back rather than the par value) . However, as noted below, CDs seem to yield more than Treasuries in most market environments for the reasons discussed there.

Liquidity - Treasuries are the most liquid bond market in the world. CDs, by contrast, cannot typically be traded; brokered CDs exist but have fairly high spreads. In a rising rate environment, this lack of liquidity is not a problem if the CD has a put option (see below). In a falling rate environment, however, liquidating the CD for purposes such as rebalancing, tax management, or funding unexpected life events, becomes costly (at risk is exactly equivalent to the increase in market value of a bond in a falling rate environment).

Options - Many CDs have a put option which allows the investor to receive the deposit back from the bank in exchange for a penalty (typically 3-6 months of interest payments). In a rising rate environment this can be a valuable feature of CDs since it allows the investor to invest in a new higher yielding CD. Be certain that any put option is a contractual agreement at the sole discretion of the bondholder in the Truth in Savings disclosure; vague suggestions not embodied in the contract on this point are apparently common. Often CDs have a "death put" that can be useful in estate planning. Treasuries no longer have embedded call options[2] and most CDs do not have call options, so if interest rates decline the investor can continue to hold the higher yielding note or CD to maturity. However, CDs are subject to a certain type of call risk--the risk that if a bank fails the FDIC might not continue to honor the terms of the original CD agreements, especially if the CD offered premium rates. The amount at risk is exactly equivalent to the increase in market value of a bond in a falling rate environment.

Reinvestment risk - Most CDs include an option to reinvest coupon payments at the CD's rate. Bonds, by contrast, pay a coupon which must be reinvested by the individual, generally at lower rates (unless the yield curve is inverted). This also leaves the investor exposed to reinvestment risk of the interest-on-interest component of bond returns. Because of this difference, however, care should be used in comparing rates of bonds vs. CDs to ensure the APY of one is compared to the APY of the other.

Purchasing convenience - Some individuals prefer dealing directly with their local bank when buying a CD; others prefer dealing with a broker of their choice. Another consideration in convenience is that CD yields vary widely depending on the issuer, and time must be spent locating the highest yield (and switching between institutions to seek out the highest yield). Treasuries can be bought at auction, often at zero cost, from a bank, brokerage account, or Treasury Direct. The treasury investor faces transaction costs if the security is sold on the market prior to maturity; the CD investor faces early withdrawal penalties for cashing in the CD prior to maturity.

Credit risk - Both CDs and Treasuries are obligations of the U.S. Government, and are therefore considered to have no credit risk. CDs must remain under certain purchase limits to maintain this feature.

Taxation - Treasury bills and notes are exempt from state taxation; CD's are subject to both federal and state taxation.

Market history

Because CDs cater primarily to the individual investor market, whereas Treasuries can be traded in large volumes by institutional investors as well, and because the characteristics of the bonds differ (particularly with regards to taxation, liquidity and options), yields on Treasuries and on CDs are never exactly alike.

Market data for CDs can be difficult to come by, because for the individual investor a little time searching can often yield above-average rates in the CD rate. Nevertheless, the data presented below is likely a good first approximation of the historical behavior of the two bond categories, at least for ultra-short maturities. The data shows that on average 6-month CDs had higher yield than 6-month Treasury Bills. Longer issues may behave much differently, because the options and liquidity differences become more pronounced over longer holding periods.

See also

References

↑An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. Put Option, from Investopedia

↑An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period. Call Option, from Investopedia